Download - Strictly Financials 2014: Understanding Financial Statements by Jimmy Gentry

Understanding Financial Statements

Strictly Financials

Jan. 2, 2014

Strictly Financials 2

Donald W. Reynolds National Center For Business Journalism At Arizona State University


n  James K. Gentry, Ph.D. n  Clyde M. Reed Teaching Professor n  School of Journalism and Mass Communications n  University of Kansas n  [email protected]


Types of Statements n  Public n  Private

n  Financial statements conforming to public company statements

n  Non-profits


Important Terms n  Unaudited n  Audited n  Accountants n  Certified Public Accountants (CPAs) n  GAAP, FASB, AICPA, PCAOB


Assessing a Company n  Context n  Trends n  Rules n  Outsiders n  Insiders


Annual Report,10-K n  Annual report,10-K wrap, 10-K n  Auditor’s report: Clean, qualified? n  MD&A or Management’s Discussion

and Analysis n  Financial statements and footnotes n  Management’s letter if annual report

Traditional Auditor’s Report n  Independent auditor’s opinion on whether

financial statements are presented fairly in all material respects, in accordance with GAAP: n  We looked at these statements n  They’re management’s responsibility; we’re just

here to express our opinion n  We followed the rules in our audits and here’s

what an audit involves n  In our opinion, the statements fairly present the

company’s position



Auditor’s Report by Category

n  Clean or Unqualified n  Qualified n  Disclaimer n  Adverse


New Auditor’s Report n  Combines traditional report with “internal controls” requirement of Sarbanes-Oxley Act


Sarbanes-Oxley Act of 2002

n  Response to abuses with Enron and WorldCom as catalysts

n  New responsibilities, resources for SEC n  Created PCAOB n  Major emphasis on “internal controls” n  More disclosure for public companies


Sarbanes-Oxley Act n  Analysts must state potential conflicts of interest n  Limited types of services accounting firms can

provide to public company clients n  Companies disclose in 10-K the fees pay to auditors n  Recent concerns n  Consulting

n  CEO, CFO attest to accuracy, completeness, fairness of financial statements

n  Rigorous penalties for fraud, other misdeeds n  Clawbacks


Public Company Accounting Oversight Board n  Created by SOX to oversee accounting n  Began operating in 2003 n  SEC appoints five members to five-year

terms n  Two members must be or have been CPAs n  All members must be “financially literate” n  In 2008, Supreme Court upheld PCAOB but

said SEC couldn’t remove board members


PCAOB’s Duties

n  Set rules on “auditing, quality control, ethics, independence, and other standards…”

n  Conduct “inspections” of accounting firms

n  Conduct “investigations and disciplinary proceedings”

n  Enforce compliance with SOX


Section 404: Internal Controls n  “Management Assessment of Internal

Controls” n  Each 10-K must contain an “internal control

report” that: n  States management is responsible for internal

control structure and procedures n  Contains an assessment on effectiveness of

internal control structure and procedures


Management on the Spot n  Section 404: Management must evaluate and

test internal controls over financial reporting, including anti-fraud programs, annually.

n  Management certifies that it does (or doesn’t) have adequate internal controls in place.

n  Independent board members easier to attract n  Auditor attests to adequacy of controls. n  Management to be forced to answer for

fraudulent activities, misconduct, etc.


Private Company Impact n  Banks, insurers requiring companies to

embrace SOX. n  Now most private firms have audited financial

statements n  If private company owners want to sell to

public company, must be in compliance n  Private equity funds more willing to invest in

companies in compliance n  Best outside directors


Non-Profit Impact n  Audit committees, independent members n  CEO, CFO attest to accuracy, completeness,

fairness of financial statements n  Financial statements more accessible n  Codes of ethics n  Rules governing transactions with “insiders”

Goal of accounting n  Record, classify and report financial

transactions. To provide managers across the organization with information that facilitates: n  Control of activities and expenditures n  Refinement of operational plans n  Accountability n  Reporting on project outcomes n  Writing of bids for new funds



Goal of Finance n  Maximize shareholder wealth as

reflected in market price of the stock n  Achieving this goal requires financial

manager to focus on economic profit, not accounting profit


Financial Decisions n  Investing decisions: Types of assets

firm wants to hold. n  Financing decisions: Acquisition of

funds needed to support long-term investments.


Generally Accepted Accounting Principles n  Guidelines based on theory and

practice n  Evolved over time n  Procedures, concepts and standards


GAAP n  Periodicity n  Going concern n  Economic entity n  Monetary unit n  Full disclosure n  Historical cost n  Consistency


GAAP n  Materiality n  Industry practices n  Conservatism


Specialized Industry GAAP n  Banking and thrift industries n  Benefit plans, including pension funds n  Broadcasting industry n  Cable television industry n  Computer software n  Finance companies n  Investment companies


Cash or Operating Cycle n  Cash n  Purchase inventory n  Produce product n  Sell product n  Cash


Cash or Operating Cycle (cont.) n  “Cash”

n  Cash n  Receivables and payables n  Debt

n  Inventory n  Raw materials n  Work in progress n  Finished goods


Cash or Operating Cycle (cont.) n  Sell product

n  Accounts receivable n  Cash

n  Cash n  Collect receivables as cash

n  Pay off payables n  Start over


Accrual Method n  Records revenues when the the “sale”

occurs n  Records expenses when the bill is

received n  IE, transactions enter the financial

records when they occur, not when cash changes hands

n  Accrual method, therefore, shows “scores,” not real spendable dollars


About These Numbers: They’re Squishy n  Goods will not necessarily be paid for n  Goods are not necessarily going to be

kept n  Inventory might be out of date, obsolete

or unsellable n  Status of some inventory may be

uncertain n  Intangible assets are estimates


About These Numbers: They’re Squishy (cont.) n  Machinery or other fixed assets might

be obsolete or falling apart long before the so-called useful life is up

n  Goodwill n  Accounting conventions n  Timing issues n  Bottom line: In many ways, statements

are a collection of estimates.


Because They’re Squishy n  You need to know the rules and

assumptions used to create the numbers


Income Statement or ... n  Statement of earnings n  Statement of operations n  Statement of income and

comprehensive income


Income Statement n  Covers a period of time, typically a year

or quarter n  Reports income from ongoing activities n  Reports income from activities beyond

management’s control (comprehensive income)

n  Involves estimates


Basic Income Statement n  Sales or revenues n  Expenses n  Taxes n  Net income or profit


Income Statement n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit n  Other income/expenses n  Interest n  Income taxes n  Net income or profit


Cost of Goods Sold n  Expenses incurred in the cost of

manufacturing or creating or acquiring the product the company sells.


Cost of Goods Sold n  Manufacturer: What the company pays

for inventory, i.e. raw materials and supplies used to make its product(s). Includes price of raw materials plus cost of turning it into a product, and transportation costs, i.e. direct factory labor, overhead costs, energy costs. Inventory is largest percent of CGS for manufacturer.


Cost of Goods Sold

n  Retailer: What the company pays suppliers for the products it sells on its shelves. Only the cost of merchandise purchased for resale, not the cost of providing the service to customers.

n  Service business: Since it doesn’t make or sell a product per se, typically find a modest CGS.


SGA n  Includes office expenses, accounting,

shipping department, advertising, R&D, depreciation and other expenses that can’t be directly attributed to particular items for sale.

n  Often includes depreciation and amortization.


Other Income/Expenses n  Discontinued items n  Unusual/extraordinary items n  Changes in accounting principle n  Impairment charge n  Sale of investment n  Minority interest


Thinking Inside the Box n  Revenues n  Minus cost of goods sold n  Equals gross profit n  Minus operating expenses n  Equals operating profit n  Minus or plus other expenses/income n  Minus or plus interest expenses/income n  Minus income taxes n  Net income


Inside the Box Earnings n  Sales or revenues n  Cost of goods sold n  Gross profit n  Operating expenses

n  Sales, general and administrative n  Depreciation, amortization

n  Operating profit


‘One-Time’ Gains That Reoccur n  Don’t be fooled by extraordinary items

that make the net income look better than it really is

n  Extraordinary items should be both unusual in nature and infrequent in occurrence

n  Examples: Writedowns, restructurings, etc.


Earnings Per Share n  Basic earnings per share

(Bloomberg) n  Diluted earnings per share (Wall

Street Journal, fully diluted)

Calculating EPS n  Basic: Net income for period divided by

weighted average number shares outstanding.

n  Diluted: Net income for period divided by weighted average number shares outstanding for period, plus assumption of exercise of all potentially dilutive instruments.


Dividend n  Company’s board of directors decides to

distribute a portion of a company's net income to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share).


Dividend Payout Ratio n  The percentage of a company’s net

income that is paid to shareholders in dividends.


Dividend Payout Ratio Dividend per share Earnings per share Dividend payout Net Income for same period


Payout Ratio Calculation Dividend payout Net income same period $622 million $961 million Ratio ratio = 64.7 percent


Dividend Yield n  How much a company pays out in dividends

each year in relation to its stock price. n  A way to measure how much cash flow you

are getting for each dollar invested in an equity position. Investors who require a minimum stream of cash flows from their investments can secure this by investing in stocks paying relatively high, stable dividend yields.


Dividend Yield Calculation Annual dividend per share Stock price per share $1 vs. $1 $20 $40 5% 2.5% Strictly Financials

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Dividend Yield Annual dividend per share Stock price per share $1.84 $60.64 Dividend yield = 3.03 percent Strictly Financials

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Looking at Dividends n  In general, investors react poorly to a

decrease in dividends, and the stock price usually declines as investors seek other dividend-paying stocks.

n  A stable dividend payout ratio indicates a solid dividend policy by the company's board of directors.



Balance Sheet n  It balances n  Assets = Liabilities + Shareholders’

Equity


Assets n  Current assets

n  Cash and cash equivalents n  Accounts receivable n  Inventories n  Prepaids

n  Investments and other assets


Assets n  Property, plant and equipment, net

n  Land and improvement n  Buildings and improvements n  Equipment n  Less accumulated depreciation

n  Goodwill and other intangibles


Goodwill and Impairment n  Difference between what a business

pays to buy another company and the book value (total assets minus total liabilities) of that company


Liabilities n  Current liabilities

n  Accounts payable n  Accrued liabilities n  Income taxes n  Current maturity of long-term debt

n  Noncurrent liabilities n  Long-term debt n  Deferred income taxes

n  Commitments and contingencies


Shareholders’ Equity n  Capital stock

n  Preferred stock n  Common stock

n  Additional paid-in capital n  Retained earnings n  Treasury stock

n  Total shareholders’ equity n  Total L + OE


Statement of Cash Flows n  Record of cash provided by cash

sources and of cash consumed by cash uses.


Cash Flows (cont.) n  Information about use of cash n  Information about investing and

financing n  Ability to continue as a going concern n  Ability to generate future positive cash

flows n  Ability to meet obligations and pay

dividends


Cash Flows n  From operations n  From investing n  From financing


Flexibility n  Companies have some flexibility in

categories for entries. n  Total change in cash, however, will not

change. n  Overwhelming majority of all accounting

standards deal with balance sheet and income statement, not cash flows statement.


Free Cash Flow n  Powerful tool for making a company

successful n  Powerful indicator for investors n  Cash that is left over after productive

capacity is maintained or expanded n  Permits expansion, paying down debt,

buying back shares, etc.


Free Cash Flow (cont.) n  Several ways to calculate it n  Companies create their own models n  Gross way to do it:

n  Cash from operating activities n  Minus capital expenditures n  Equals free cash flow


American Standard Model

n  Cash from operating activities n  Minus capital expenditures n  Plus proceeds from disposal of property n  Plus proceeds from sale and

leasebacks n  Equals free cash flow

Free Cash Models n  ‘Gross’ method n  American Standard method n  VF method

n  Cash from operating minus cash from investing


Keys to Looking at Cash n  Cash from operations n  Capital expenditures (cap ex) n  Free cash n  Cash and cash equivalents at the end

of the year



Looking at the Numbers n  Note changes in amounts year to year, especially

revenues and expenses n  Note numbers that are significantly larger or smaller

than the previous period n  Look at trend line for sales/revenues, operating

income and net income. Calculate percentage change for each.

n  Look at cash flow n  Look at free cash flow n  Tie the numbers to the footnotes.


Techniques n  Calculate percentage change n  Trend analysis n  Common size analysis n  Ratio analysis